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Judging by the purchasing frenzy of Italian bonds today, most of it emanating out of Japan, which, after last night's epic snafu involving JGBs and the double halt of bond trading, may have spooked the "New BOJ-frontrunning Normal" Mrs. Watanabe, not to mention Albert Edwards' recent rekindled love affair with the Mediterranean country, one may have left with the impression that all is well, and Italy is "safe." Not so fast: according to Bridgewater, the world's biggest hedge fund (after the ECB and the NY Fed of course), whose daily letter today is titled "Could Italy Blow Up The Euro?" things in Italy are hardly as rosy as market conditions make them appear (although as the BOE itself admitted, any link the policy vehicle known as the "market" may have had with economic fundamentals is long gone), and in fact may be set to get far worse.

Some of the key highlights:

Economic conditions in Italy are as depressed as they've been since the end of WWII, the economy is still contracting, Italy's banks are in terrible shape, private sector lending is very strained, and the ECB's policy is not resolving the problems. As is typical in countries enduring this level of economic pain, the political situation is starting to get pretty chaotic. Bersani, the top vote getter in the recent elections, has been unable to form a government, new elections this year are increasingly likely, and recent polling suggests a dead heat among Bersani, Berlusconi, and the anti-establishment party of Grillo. Surge in support for Grillo creates a risk because it is not entirely clear what he would do if he came to power. He has made a clear promise to put the euro to a vote and generally thinks that the European fiscal and monetary policies have been a bad deal for Italy. Obviously, an attempt to revisit those policies by a country as systemically important as Italy could destabilize things fast, and the risk of a radical outcome is growing. And over the past few months there are indications of that risk getting priced in and putting pressure on Italy, particularly on its banking system. Italian banking spreads are up; there has been a modest pullback in banks' wholesale funding, a modest increase in their ECB borrowing and no bond issuance. So far, the Italian sovereign has not come under as much pressure. Spreads have risen a bit, but issuance has been steady, and the government is so far meeting its needs for the year. However, there are some indications that things are getting tighter for them (a postponed 30 year auction, worse auction technicals, weaker foreign demand). And there isn't much margin for error, as the gross issuance needs are big and steady. And the sovereign is still relying on Italian banks to buy a lot of bonds.

So there is a risk that if economic conditions continue to be terrible and the political situation gets more extreme, the pressure on the banks will increase, and the sovereigns could start to have trouble (and with the political uncertainty, should the need arise, who would the Troika negotiate with?).

Those who have been following our coverage of the Italian fiasco in recent months will be quite aware of all of Bridgewater's caveats, but here are some of the important drill downs, especially as pertains the still woefully insolvent (and now leaking deposits) banking sector. To wit:

Italian banks increasingly look strained, both outright and relative to Spain. Bank CDS spreads have risen 150 basis points and bank eguity prices have fallen 30% in the past two months, and there are some indications of stress in the bank funding flows. Unlike in Spain, Italian banks have not decreased their reliance on the ECB at all, and in February they actually increased their net ECB funding. At the same time, wholesale funding lines with banks and non-banks are falling, and Italian banks have had substantial bond redemptions that they haven't rolled in February and March. Italian banks are getting liquidity by reducing private sector loans and through a healthy inflow of retail deposits, which is helping them to pay for the wholesale funding that is leaving. Italian banks bought government bonds at a healthy pace in January, but the purchases slowed in February, and they have been selling foreign corporate and bank bonds for the past six months.

Funding costs for the banks have risen about 150 bps over the past few months and have noticeably diverged from sovereign spreads

And the stocks of the big Italian bank have sold off pretty sharply. The stock prices of the three largest Italian banks are down almost 30% since late January.

Italian bank borrowing from the ECB has been increasing. Italian banks have only paid down a modest amount of their 3year LTRO borrowings, and their net reliance on the ECB increased by €11 bn in February (€6bn in new borrowing and a decline of €5bn in deposits). Spanish banks on the other hand have been reducing their ECB reliance at a rapid pace. Italian banks continue to fund 18% of domestic GDP and around 10% of their balance sheets at the ECB

The quality of Italian bank balance sheets has been deteriorating for years. NPLs are still rising and Italy's banking system is on course to see historically bad losses.

And the scariest news for those few who are taking seriously the warning from UniCredit's CEO that deposit confiscations in Italy may well happen, is that NPL are soaring, and are likely orders of magnitude worse than the official data. Just like in Cyprus.

When we go asset-by-asset through the bank loan books, and look at various deleveraging cycles to gain historical perspective, we think a reasonable estimate is that Italian banks will end up with full cycle losses of 10% on their €1.5trIn of domestic loans, which would be a bit worse than bath the 1993 Spanish recession and similar to the recent US crisis (though the context of the Italian cycle would be that conditions continue to be worse and stimulation continues to be less than the recent US case, but with better quality loans and less leveraging up).

To summarize the adverse view:

So that's the situation in Italy: Conditions are depressed and play no small part in the prevailing political uncertainty. Increasing pressures are being placed on an already-stressed banking system. The sovereign is pretty reliant on those banks to buy their bonds, and there are modest signs of those sovereigns also getting pressured. But, there are a few countervailing forces: Growth conditions in Italy will probably stabilize a bit as the big impact of the fiscal austerity fades (but a new round of financial instability cuts the other way). The probability that Grillo actually gets some kind of mandate and then takes a radical path still seems low. The ECB's commitment to do what it takes should for now keep spreads from moving out too much. But the possibility of a dangerous outcome is real and one we're continuing to monitor.

So for all those scrambling to frontrun other lemmings in the global capital reallocation game, be it rushing into U.S. stocks or Italian bonds, be careful: the fact that others are doing it doesn't mean massive losses aren't lurking just around the corner.

Don't worry though, if all the bad news outcomes as forecast do hit, the ECB is prepared. After all, as was made abundantly clear yesterday, it has "No Plan B."